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What's in common with these dates? These are all of the dates during the past two years that the market has reached the formal definition of "oversold" as explained by J. Welles Wilder. That is, the market has crossed below the "30″ level on the Relative Strength Index. In the past four years, shortly after the market reaches this point, the market had made a lower, panic low, then reversed back up. Especially with the bullish hammer formation we saw on Friday, I believe that a market bottom may be in the near future. The hammer occurred on very high volume especially in inflationary issues, such as energy stocks. Therefore, I would not be surprised if energy stocks emerged as a market leader in the next rally.

"A stock is never too high to go higher, nor too low to go lower." That's a quote from one of my favorite books, ​Reminiscences of a Stock Operator, ​ as the main character was explaining his reasoning for buying stocks as they reach new highs. This will be one of those "buy high, sell higher" type of trades.

EOG resources has been a market leader in the energy sector as of late. Below is a ratio chart of the energy sector ETF, (NYSEARCA:XLE), divided by price of (NYSE:EOG). These "ratio charts" are used for comparing two stocks, and give an easy to read visual representation of which stock is outperforming.

(click to enlarge)

As you can see, the line is clearly declining, which means that EOG is outperforming. This trend actually started in October of 2011, when EOG mustered enough strength to become a market leader.

Normally, my analysis is focused on short-term, exact predictions, but not in this post. Ever since the August 2011 mini-panic, pundits have been calling for a new bear market. Obviously, they were early, but we cannot dismiss the importance of this decline, even over a year later. During that decline, the market printed some of the highest negative weekly volumes since fall of 2008. During that nervous August, the influx in selling volume indicated an enormous rise in selling pressure in the market. Those same measures of selling pressures, not recovered from the August collapse, are still telling investors to be cautious.

The chart below shows weekly data of the S & P 500 ETF with the On-Balance Volume (OBV) study on the lower graph. The OBV is calculated by adding the index's total weekly volume if the index's price finishes higher and subtracting if it falls.

(click to enlarge)

Generally, the market OBV will top before the actual index does. This is typical. In idealized Wyckoff market top, a high volume downward correction is very common before the market makes its final high. That high volume correction drives the OBV down so much that the measure cannot make new highs. That is our warning. This signal also provided warnings before the 2000 & 2007 market tops.

In addition to the OBV divergence, note the actual volume statistics. Since 2009, the market has been trending upward. However, volume has been consistently falling, especially on rallies. In fact, as the market rallied in August, some of the lowest trading volumes in years were recorded. Then, a glance at shorter term charts shows that volume has been increasing on declines and decreasing on rallies. In short, the demand that has been propping up the market is stalling out.

Frequent readers know my opinion. One more rally, then head for the emergency exit.

Happy trading!

~Chris Diodato

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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